The adverse effects of rising interest rates

Rising and falling interest rates offer a special risk to stock investors. Historically, rising interest rates have had an adverse effect on stock prices.

Hurting a company’s financial condition

Rising interest rates have a negative impact on companies that carry a large current debt load or that need to take on more debt because when interest rates rise, the cost of borrowing money rises, too. Ultimately, the company’s profitability and ability to grow are reduced. When a company’s profits (or earnings) drop, its stock becomes less desirable, and its stock price falls.

Affecting a company’s customers

A company’s success comes when it sells its products or services. But what happens if increased interest rates negatively impact its customers (specifically, other companies that buy from it)? The financial health of its customers directly affects the company’s ability to grow sales and earnings. For a good example of this situation, consider what happened to Cisco Systems in 2000. Because a huge part of its sales went to the telecommunications industry, Cisco’s profitability depended on the health of that entire industry. The telecom industry’s debt ballooned to $700 billion. This debt became the telecom industry’s financial Achilles heel, which, in turn, became a pain in the neck to Cisco. Because telecom companies bought less (especially from Cisco), Cisco’s profits shrank. From March 2000 to March 2001, Cisco’s stock fell by nearly 70 percent! As of September 2001, Cisco’s stock price continued to decline because the companies that were Cisco’s customers were hurting financially.

Impacting investors’ decision-making considerations

When interest rates rise, investors start to rethink their investment strategies, resulting in one of two outcomes:

Investors may sell any shares in interest-sensitive stocks that they hold. Interest-sensitive industries include electric utilities, real estate, and the financial sector. Although increased interest rates can hurt these sectors, the reverse is also generally true: Falling interest rates boost the same industries. Keep in mind that interest rate changes affect some industries more than others.

Investors who favor increased current income (versus waiting for the investment to grow in value to sell for a gain later on) are definitely attracted to investment vehicles that offer a higher rate of return. Higher interest rates can cause investors to switch from stocks to bonds or bank certificates of deposit.

Hurting stock prices indirectly

High or rising interest rates can have a negative impact on any investor’s total financial picture. What happens when an investor struggles with burdensome debt, such as a second mortgage, credit card debt, or margin debt (debt from borrowing against stock in a brokerage account)? He may sell some stock in order to pay off some of his high-interest debt. Selling stock to service debt is a common practice that, when taken collectively, can hurt stock prices. The stock market and the U.S. economy face perhaps the greatest challenge since the Great Depression — debt. In terms of Gross Domestic Product (GDP), the size of the economy is about $11.5 trillion (give or take $100 billion), but the debt level is about $37 trillion. This already enormous amount does not include $44 trillion of liabilities such as Social Security and Medicare. Additionally (Yikes! There’s more?!), some of our financial institutions hold over $50 trillion worth of derivatives. These can be very complicated and sophisticated investment vehicles that can backfire. Derivatives have, in fact, sunk some large organizations (such as Enron), and investors should be aware of them. Just check out the company’s financial reports.

Because of the effects of interest rates on stock portfolios, both direct and indirect, successful investors regularly monitor interest rates in both the general economy and in their personal situations. Although stocks have proven to be a superior long-term investment (the longer the term, the better), every investor should maintain a balanced portfolio that includes other investment vehicles, such as money market funds, savings bonds, and/or bank investments. A diversified investor has some money in vehicles that do well when interest rates rise. These vehicles include money market funds, U.S. savings bonds (EE), and other variable-rate investments whose interest rates rise when market rates rise. These types of investments add a measure of safety from interest rate risk to your stock portfolio.